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South Africa: The Elimination of the Foreign Income Exemption

28 Aug 2017

I’ve had a few requests to write something about the National Treasury’s proposal to scrap the foreign income exemption for South African taxpayers. This may seem like a small and arbitrary issue of tax law (and a fairly specific one at that), but it’s yet another example of the current trend in global tax practice.

What is the foreign income exemption?

In the world of tax law, nearly all tax authorities use one of two different methods for determining what income they can tax you on:

Source-based (or territorial) taxation; or

Residency-based taxation.

To give you some examples:

Botswana still has a territorial taxation system. So if you are a Botswana resident, and you have a foreign investment that earns some income for you, then that income falls outside their tax system (ie. it’s tax free income).

In contrast, South Africa has a residency-based taxation system. So South African residents are taxed on their worldwide income, regardless of where it was earned.

As a side-n0te. the United States is a bit of an anomaly: they have a citizenship-based taxation system (as well as a residency-based taxation system for non-citizens). So even if a US citizen lives permanently abroad, they will still have to submit a tax return each year.

And that US anomaly highlights a key issue with ‘residency-based’ taxation: how do you define residency?

And what do you do when someone is technically ‘resident’ in more than one country?

Some tax codes (like South Africa’s one) deal with the general problem by saying:

“All citizens are deemed to be tax residents”; and

“All non-citizens who are in the country for longer than a specific period of time are also deemed to be tax residents”; but

“If a citizen lives outside the country for longer than a specific period, then even though they are tax resident, they will not have to pay any South African tax.” (this is the foreign income exemption).

The more specific issues are dealt with via Double Taxation Agreements (DTAs).

So why is the South African Treasury trying to do away with the primary exemption?

Apart from the obvious “this will increase tax revenue” part (which it will), the Treasury’s main argument is:

When this exemption was created, South Africa did not have many DTAs – so it needed a general exemption.

But now South Africa has DTAs signed with more than 78 countries.

So we don’t need the general exemption any more.

Despite the fact that there are at least 115 other countries in the world, with whom South Africa has not signed a DTA.

But more importantly:

It has come to Government’s attention that the current exemption creates opportunities for double non-taxation in cases where the foreign host country does not impose income tax on the employment income or taxes on employment income are imposed at a significantly reduced rate*.*you can read the full Treasury justification here.

That is:

“The exemption is being abused by people going to work in countries where they don’t have to pay very much tax.”

I’m not sure when it suddenly became so ‘illicit’ or ‘bad’ to go and work in a country with a lower tax rate than South Africa’s. But apparently, it is.

And to be clear: there are only 27 countries in the world (at the time of writing) that have a higher top individual tax rate than South Africa. So (I guess) you’re a tax deviant if you move to one of the other 168 countries in the world (or 170, if you’re going to include the observer states at the UN).

The morality aside…what of the cost of living?

In practice, the foreign income exemption does more than avoid double taxation. It also avoids a situation whereby the host country’s cost of living is significantly different to South Africa’s. And it avoids dealing with foreign currency turbulence.

Consider this:

Let’s say that I am an expat, living and working in Mauritius.

For the last ten years, I haven’t visited South Africa.

And I’ve been earning a salary of $24,000 per year, taxed at a flat rate of 15%.

With my $20,400 after-tax salary, I spend $6,000 per year on rent, and the rest of daily living.

But if I were to suddenly lose the foreign income exemption, I’d be subjected to the whims of the USD:ZAR exchange rate, and I’d pay tax on the excess.

Here is my original profile (in USD terms):

Here is a revised profile (in ZAR terms, after losing the foreign income tax exemption):

To be clear, the SA expat has not had a change in his actual salary. But in South African terms, his salary has almost doubled – with all the tax consequences that go with it.

The biggest problem here is that the taxation rate is being applied to a salary that has been determined with respect to market forces in a completely different economy, under a completely different exchange rate profile. South African nationals working abroad will have these roving after-tax incomes that bear no relation to the daily reality of their costs of living.

It makes no sense.

And the ideological basis for this is…what exactly?

That these individuals are somehow ‘avoiding’ tax by living and working in a different economy?

So, I guess, let’s force them all to return home. So that they can join the unemployed 30% of the work force.

Comments

In the example you give about living in Mauritius, surely you would not be an SA tax resident (given they haven’t visited in 10 years) and hence the changes to the foreign tax exemption are irrelevant from your perspective? My understanding is that it will only affect people who are still tax resident but spend some part of the year working in other countries.

Hey Dave! Thanks for this response. Unfortunately, ‘tax residency’ is a bit of a tough one, because it’s not especially well-defined. If I’m an SA citizen, who has lived and worked in Mauritius for 10 years on a work visa, then SA might still been termed my country of *ordinary* residence. Yes, I think that you’d have a great case to argue that you shouldn’t be a SA tax resident. But you’d still have to argue it. And you may have to rely on some clauses in a DTA that would cover this type of situation (or those clauses may firmly place you as an SA tax resident, if you hadn’t formally emigrated). Either way, you’re suddenly facing ambiguity (where before, there was no question). And the trouble is, when there is ambiguity of this kind, tax authorities don’t tend to lean in your favour when they’re assessing you.